• Kai Wu

The Platform Economy

December 2020


Executive Summary

The technology platform has emerged as the preeminent business model after many years in ascent. We use natural language processing to identify platform companies and show that they have significantly outperformed the stock market. Platforms’ powerful network effects generate positive feedback and monopoly dynamics, which are disrupting traditional valuation approaches.


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The Rise of the Platform

March of the Unicorns 🦄

Last week, Airbnb and DoorDash had their highly anticipated initial public offerings (IPOs). DoorDash went first. The IPO priced at the top of the range and rocketed +86% on the first day of trading to a $72 billion valuation. Airbnb followed the next day to even greater euphoria, jumping +113% to a $100 billion valuation. Even Airbnb’s CEO was left speechless.


Exhibit 1

And There Was Much Rejoicing!

Source: Pitchbook, Bloomberg, Sparkline

While operating in very different industries, these companies employ a common business model. They are both platform companies. Platform companies externalize the means of production. They do not own homes or employ drivers. Instead, they profit from orchestrating networks of external consumers and producers.


This marks only one of many milestones in the platform parade. Many iconic platform companies such as Uber and Slack went public in the past couple years. Even Warren Buffett, who publicly eschewed IPOs for decades, invested $735 million in Snowflake’s public debut.


Exhibit 2

The Platform Parade 🎉

Source: SEC, Sparkline

Despite all the fanfare, these newly public companies are dwarfed by their platform predecessors. The five largest US companies (Apple, Microsoft, Amazon, Google, Facebook) all operate extremely successful technology platforms. These tech giants represent $7.4 trillion in market cap and 22% of the S&P 500. The unique features of the platform model have helped these firms reach an unprecedented scale.


The “platformization" of the stock market is not just about splashy IPOs and tech giants. The number of platforms in the top 500 US stocks has steadily grown from 40 to 100.


Exhibit 3

It Feels Good to Be a Platform

Source: SEC, Sparkline

We expect this trend to continue. There are 500 private companies valued over $1 billion. Many of these “unicorns” are platform businesses ripe to join the public markets in the next several years.


Exhibit 4

Platform Unicorns

Source: CBInsights, Sparkline

The Many Shapes of Platforms

Platforms can take many shapes. They can connect a single type of user (Facebook) or different types (iOS App Store). Producers and consumers can be the same individuals (LinkedIn) or different (YouTube). The item exchanged can range from rides to photos to software applications.


In order to make sense of this wonderful diversity, we’ll use the taxonomy created by Cucumano, Gawar, and Yoffie (2018) to categorize platforms into two broad types:

  • 💱Transaction platforms serve as intermediaries for direct exchanges or transactions between users

  • 🔬 Innovation platforms provide a technological foundation upon which other firms develop complementary innovations

The next exhibit shows a few examples of platforms and how they fit into this taxonomy.


Exhibit 5

Platform Taxonomy

Source: Sparkline

It is important to note that we use the term “platform” to mean the business model. This is distinct from the term “technology platform,” which describes pretty much every software company. E-commerce companies such as Chewy are retailers that happen to utilize technology platforms for more efficient distribution over the internet. Similarly, SaaS firms are just product companies that use the cloud to streamline deployment.


Why Now?

The platform business model is not new. Marketplaces have existed since ancient times to facilitate the exchange of crops, cattle, spices, commodity futures, stocks, and other goods. Even the shopping mall is a type of platform. So why are platform companies only having their moment now?


The value of platforms is a nonlinear function of the size of their networks (more on this later). Thus, their potential has increased exponentially as globalization and technology have connected the world. Railroads, electricity, air travel, telephones, the Internet, and smartphones have made the world a much smaller place. The ancient spice market may have at best connected thousands of merchants. Today, Facebook alone serves 2.7 billion active monthly users.


The modern digital platform has taken this primordial concept to epic proportions. The dominance of firms such as Google and Amazon is just another of the many side effects of the megatrends of globalization and technology.


Platform Stock Returns

Identifying Platforms

So how have the stocks of platforms done? In order to conduct a rigorous study, we need a way to classify platform companies. Despite their dominant economic position, empirical work on platform companies is extremely limited. Most writing on platforms is tailored toward entrepreneurs, managers, and venture investors.


The few attempts to study the empirical characteristics of publicly traded platform companies begin with manually defined lists. The next exhibit compares the constituents of three such lists. For consistency, we only include stocks that were in the S&P 500 in 2015 (when the lists were compiled).


Exhibit 6

Identifying Platforms Is Subjective

Source: Cusumano, Gawar, and Yoffie (2018), Moazed and Johnson (2016), Ravichandran, Lu and Lee (2017), Sparkline

It is clear that identifying platforms is subjective. While eBay and Facebook are clearly platforms, there is less consensus around innovation platforms such as Oracle and Adobe. Researchers also seem to be less interested in old-economy platforms such as financial exchanges and credit card companies despite their ample network effects. Determining where to draw the line for hybrid companies such as Apple that operate both platforms and traditional businesses introduces additional subjectivity.


However, the biggest problem with human-compiled lists is the introduction of survivorship bias. While it is easy to think of success stories, we have a tendency to forget the losers. The historical performance of platform companies will be grossly overstated if these companies are selected with the benefit of hindsight.


Company Embeddings

We can address these challenges using machine learning.


In Investment Management in the Machine Learning Age, we introduced “company embeddings,” which we used to compute the semantic distance between descriptions of companies’ businesses in their 10-K filings. In Value Investing Is Short Tech Disruption, we used this technique to identify companies that are described similarly to the FAANG stocks. While we could use this approach to find failed platform companies, it would still require manually defining a list of platform companies.


Thus, we will instead introduce a new way to use company embeddings. The key insight is that while we have so far only compared companies’ 10-K business descriptions to each other, there is nothing preventing us from comparing these passages to any arbitrary text document.


We will compare the 10-Ks to two articles from platform experts Eisennman, Parker and Van Alstyne (2006, 2007). We use both articles as one deals with transaction platforms and the other innovation platforms. We also mask company names so that our algorithm focuses only on the general features of the platform business model itself.


Exhibit 7

Platform Articles for Calculating Similarity

Source: Harvard, MIT

We deliberately chose older articles to avoid hindsight bias. When they were published, the authors had no idea that Facebook and Amazon would go on to run the world. Also, note that we could have chosen from many other writings on platforms and our results would have been similar.


The next exhibit shows the similarity scores of excerpts from two recent 10-K filings to our platform articles. Platform scores can range from a high of 1 to low of -1. Despite both being technology companies, their annual filings reveal very different business models. Uber is a platform company, while Lam Research employs a traditional product model.


Exhibit 8

Technology Is Not a Business Model


Uber Technologies

We are a technology platform that uses a massive network, leading technology, operational excellence and product expertise to power movement from point A to point B. We develop and operate proprietary technology applications supporting a variety of offerings on our platform (“platform(s)” or “Platform(s)”). We connect consumers (“Rider(s)”) with independent providers of ride services (“Rides Driver(s)”) for ridesharing services, and connect consumers (“Eater(s)”) with restaurants (“Restaurant(s)”) and food delivery service providers (“Delivery People”) for meal preparation and delivery services.

Platform Score = 0.48

Lam Research

We are a global supplier of innovative wafer fabrication equipment and services to the semiconductor industry. We have built a strong global presence with core competencies in areas like nanoscale applications enablement, chemistry, plasma and fluidics, advanced systems engineering and a broad range of operational disciplines. Our products and services are designed to help our customers build smaller, faster, and better performing devices that are used in a variety of electronic products, including mobile phones, personal computers, servers, wearables, automotive vehicles, and data storage devices.

Platform Score = 0.06


Source: SEC, Sparkline

We can apply this technique to the annual filings of all public companies through time, saving us from having to read through tens of thousands of pages of SEC filings. The next exhibit shows some of the companies that our algorithm has identified as platforms.


Exhibit 9

Examples of Platforms Identified

Source: SEC, Sparkline

In addition to stalwarts such as Microsoft and PayPal, the embeddings dig up newer platforms such as Match Group (online dating), Slack (enterprise messaging), and Zoom (video conferencing).


Since the algorithm is run on a rolling basis, we can track how companies’ business models evolve over time. Amazon started as an online bookstore. However, over time it added platforms such as a third-party marketplace, Amazon Web Services, Kindle Direct Publishing, and Alexa. Amazon’s similarity score has increased over time as these platforms have grown in importance.


Exhibit 10

The Platformization of Amazon

Source: SEC, Sparkline

While we compute a continuous platform score for each company, for the rest of the analysis we will use a simpler binary categorization. We will employ a threshold of 0.33 to balance the rate of false positives and negatives.


Platform Performance

With our new definition of platform in hand, we can now explore the characteristics of platform companies.


First, we find that the popularity of the platform business model has been steadily rising. Among the top 500 US stocks, the number of platforms has increased from 40 to 100. The percentage of market cap owned by platforms has increased even more dramatically, swelling from 10 to 37%.


Exhibit 11

Platforms Rising

Source: S&P, SEC, Sparkline

The platform effect is concentrated in the communication and technology sectors. 76% of platforms today are in these industries. In addition, the share of these sectors that are platforms has increased from 30 to 60% over this period.


Second, we compare the performance of platform stocks to the rest of the largest 500 US stocks. The portfolio is reconstituted each month in order to compute performance the next month. We find that platform companies have outperformed by an impressive 8.7% per year.


Exhibit 12

Platforms Have Outperformed

Source: S&P, SEC, Sparkline

This backtest uses a market cap weighting scheme, which gives more weight to larger companies. In order to address the concern that our results are driven solely by Big Tech, we also create an equal-weighted version. This portfolio delivers similar returns, confirming that the platform effect is broad-based.


Exhibit 13

Equal-Weighted Platform Outperformance

Source: S&P, SEC, Sparkline

Third, we want to determine the source of platform profits. We can decompose the returns of any investment strategy into returns from sales growth, dividend yield and multiple expansion. These components mathematically constitute total performance. The next chart decomposes the returns of platforms relative to non-platform companies.


Exhibit 14

Platforms Fueled by Growth

Source: S&P, SEC, Sparkline

This analysis reveals platforms have won by consistently outgrowing the market. Interestingly, they did not suffer the losses from P/S contraction that would be expected if the market “efficiently” priced in higher sales growth. In fact, valuation change has not contributed meaningfully to returns with the exception of the current year.


Finally, we want to test if performance is driven by startups or mature firms. We divide our universe into companies that were founded before and after 1998. The older sample skews toward innovation platforms and includes Apple, Amazon and Microsoft. The newer sample consists mainly of transaction platforms and includes Google and Facebook. We compute both cap- and equal-weighted versions.


Exhibit 15

Mature and Startup Firms

Source: S&P, SEC, Sparkline

All four groups have handily outperformed the market, although smaller legacy platforms have lagged their larger and newer platform brethren. Platforms have been a solid investment regardless of vintage.


Why Have Platforms Thrived?

Platforms have managed to deliver strong growth through two channels: disrupting existing industries and unlocking new sources of value.


Disruption

The platform business model has been highly disruptive. As the world has become more heavily networked, platforms have been able to take market share from less efficient incumbents. Uber and Lyft are decimating the taxi industry; Google and Facebook are squeezing the advertising industry; and Airbnb is shaking up the hotel industry.


In Value Investors Are Short Tech Disruption, we used natural language processing (NLP) to classify companies as disruptive or non-disruptive. As with platforms, our disruption factor transcends the limitations of rigid industry classifications.


The next exhibit shows the overlap between platforms and disruption. We show the number of firms that fall into each bucket with some examples (for illustrative purposes only).


Exhibit 16

Platforms and Disruption

Source: Sparkline

We find that not all disruptive companies are platforms, but that most platforms are disruptive. In other words, while the platform business model is disruptive, disruption can also be driven by other forces such as technological innovation (e.g., cloud computing, e-commerce).


How Platforms Create Value

Platforms have been most successful disrupting industries with the following characteristics:

  1. Inefficient gatekeepers

  2. High fragmentation

  3. Untapped supply

These are three areas where platforms are especially well suited to create value.


Inefficient Gatekeepers

In order to access consumers, producers often have to pass through gatekeepers. Gatekeepers play an important role in curation and quality control. However, they often also have conflicts of interest and take a large cut of value. Moreover, human gatekeepers do not scale, leading them to generally ignore smaller producers who are not worth their time.


Rather than remove traditional gatekeepers, platforms have replaced them. We have seen reintermediation rather than disintermediation. Platforms such as Spotify, Yelp, Kindle Direct Publishing, and YouTube allow just about anyone to create and distribute content. Platforms lower the barriers to producer access and then solve the now greater curation problem with algorithms and crowdsourced reviews.


Platforms not only broaden access but also tend to reduce transaction costs and friction. This helps grow the size of the overall market. For example, the ease of calling an Uber has grown the overall market for car services.


High Fragmentation

A highly fragmented market consists of many small, dispersed participants. Fragmented markets suffer from a lack of liquidity and limited network effects.


Platforms aggregate fragmented supply into a single, large market. In building Alibaba, Jack Ma intentionally focused on the fragmented Chinese exporter, saying: “Among the great density of small companies here, most do not have channels to the large trading companies. Most have no way to reach a market. Simply by going through our Alibaba network, they can get access to all of American and Europe.” By unifying China’s fragmented small business market, he created a $680 billion behemoth.


Untapped Supply

Similar to the way Jack Ma brought Chinese suppliers into the global market, platform companies have managed to tap many previously idle sources of supply.


YouTube, TikTok, and Twitch have launched a generation of superstars that would likely not have had a platform in the traditional entertainment world. Lyft has helped increase the utilization of cars that would otherwise sit idle in the driveway. Airbnb has increased the utilization of spare rooms and homes. Etsy, 99designs, and the iOS App Store have created opportunities for independent craftspeople, designers and developers.


By replacing inefficient gatekeepers, aggregating farflung markets, and tapping underutilized supply, platforms have created robust communities and growth.


Platform Monopolies

Network Effects

In order to understand why platforms have enjoyed such success, we must study their core asset, network effects.


Network effects are a phenomenon whereby additional users enhance the value of a product to its existing users. The mathematical value of network effects is commonly modeled by Metcalfe’s Law, which states that the potential number of connections in a network increases with the square of the number of users (i.e., V ∝ n2 ).


Exhibit 17

Metcalfe’s Law

Source: SeaRates

While not a law of nature, researchers have found that Metcalfe’s Law provides a good fit of the growth trajectories of social networks such as Facebook and Tencent.


Metcalfe’s Law models the maximum number of potential connections in a network. In practice, not all users will connect with each other and networks instead form around local clusters. Uber’s network consists of thousands of isolated city-based clusters. Twitter has dozens of sub-communities organized around topics such as finance and climate change, each with its own influencers.


The social graph below illustrates how distinct clusters tend to form around the various communities in a Facebook user’s network (e.g., high school, college, and work friends).


Exhibit 18

Real Life Facebook Friends

Source: a16z, Barabasi, Griffen

We have so far only considered “same-side” network effects. “Cross-side” network effects exist when, say, attracting more developers to the Playstation ecosystem creates value for gamers by providing a wider variety of games. Finally, complementary network effects crop up when one set of users creates value for users of a separate product (e.g., Microsoft Windows and Office).


While network effects are nuanced, the most important thing to remember is that bigger is better.


Positive Feedback

Network effects generate positive feedback loops. As users join a network, the value of that network increases. This entices more users to the platform, further increasing its value. Meanwhile, as competing networks lose users, they become less valuable, leading to further defections.


These virtuous and vicious cycles are a natural outgrowth of the convexity of Metcalfe’s Law. This dynamic is common in the technology and communications industries. Famous historical examples include 1980s video recorders (VHS vs. Beta), 1990s PC operating systems (Windows vs. Apple), and 2000s social networks (Facebook vs. Myspace).


W. Brian Arthur (1996) famously coined the term “increasing returns” to describe this positive feedback effect:

“Increasing returns are the tendency for that which is ahead to get further ahead, for that which loses advantage to lose further advantage. They are mechanisms of positive feedback that operate — within markets, businesses, and industries — to reinforce that which gains success or aggravate that which suffers loss. Increasing returns generate not equilibrium but instability: If a product or a company or a technology — one of many competing in a market — gets ahead by chance or clever strategy, increasing returns can magnify this advantage, and the product or company or technology can go on to lock in the market.”

Monopoly

The endgame of positive feedback is monopoly. It is not efficient to have liquidity fragmented across hundreds of stock exchanges, social networks, or mobile operating systems. Ultimately, positive feedback will tip the market toward one or two dominant players.


We saw this dynamic play out in mobile operating systems. While originally split five ways, the market eventually tipped toward Android. Apple’s iOS survives in second place based on its tight integration with the upmarket iPhone.


Exhibit 19

Mobile OS Market Share

Source: Wikipedia, IDC, Statistica, Sparkline

In Monopolies Are Distorting the Stock Market, we examined the rise of superstar firms with supernormal profits and deep moats. Platform giants are the ultimate superstar company. Network effects provide one of the deepest moats. Once the market is “locked,” it is very challenging for upstart competitors to lure away users, resulting in supernormal profits. In a competitive market, these profits would be competed away. However, network effects prevent or at least greatly slow this mean reversion.


At the extreme, platforms can only be unseated by the obsolescence of their market. While Microsoft still controls the personal computer OS market, it failed to establish itself in the now more important smartphone OS market. Intel, seems to have made a similar mistake by passing on a deal to produce the iPhone chip. In a classic example of disruption, these firms have ceded critical markets to their rivals (Apple, Google, ARM and TSMC).


However, in spite of their missteps, these companies still got to enjoy decades of monopoly profits. Winning a platform battle is sort of like getting a patent. Patents incentivize companies to invest in R&D by offering the chance of a temporary legal monopoly. Similarly, platforms invest heavily in R&D and user subsidies in hopes of earning a period of monopoly profits.


Scale

Economists distinguish between supply- and demand-side economies of scale. Traditional industrial monopolists enjoyed supply-side scale, in which they leveraged their massive size to squeeze out cost efficiencies. In contrast, demand-side scale stems from the incremental value consumers derive from greater network effects.


Platform monopolies generally benefit from both supply- and demand-side economies of scale. Not only do they have network effects, but marginal cost is nearly zero. Platforms are the ultimate asset-light businesses. Airbnb does not own any apartments and Uber does not own any vehicles. Scaling does not require physical investment.


In their pioneering book on the information economy, Shapiro and Varian (1999) write:

“Despite its supply-side economies of scale, General Motors never grew to take over the entire automobile market… [b]ecause traditional economies of scale based on manufacturing have generally been exhausted at scales well below total market dominance… .”

In contrast, asset-light platforms with network effects are able to transcend the limits of the industrial economy. This enables them to flourish at unprecedented scale.


The flipside is that platforms will struggle while subscale. Companies must grow their networks to a critical mass before they can deliver enough value to users to earn a profit. Facebook with a single user is pointless. Nobody wants to wait 30 minutes for an Uber. Achieving scale is not a luxury but a necessity. The opposite of big is failure.


Scale economies make it extra important to carefully size up a company's total addressable market (TAM). If the market is too small, even achieving total dominance will not be enough to justify the fixed costs of building the network. Think twice before launching the “Uber for frozen yogurt!”


Competition in the network economy is quite different from the perfect competition in economics textbooks. Investors need to adopt a venture capitalist mindset, where they are effectively buying a call option on a company achieving market dominance. Platform competition is “go big or go home!” 🏂🌊


Investing in Platforms

Platforms Distort Value Investing

In Investing in the Intangible Economy, we discuss the increasing importance of intangible assets such as intellectual property, brands and network effects.


Despite their rise, financial accounting practices largely ignore intangible assets. This omission leads investors to systematically undervalue intangible-rich companies. We believe this is the primary reason for the broad-based outperformance of platform companies we saw earlier.


Moreover, this leads traditional quant value strategies to struggle with platform companies. The companies with the strongest network effects tend to look the most expensive on metrics such as price-to-book or price-to-sales.


Normally, value investors profit from the tendency of these metrics to subsequently mean revert. However, network effects create positive feedback loops. Thus, companies with strong network effects tend to get stronger while the weak get weaker.


The following exhibit shows the performance of a simple value strategy in the platform company universe. The results are the exact opposite of what value investors want. The more expensive the company, the better it does!


Exhibit 20

Value Working in Reverse

Source: S&P, SEC, Sparkline

Admittedly, value hasn’t worked very well in general since 2008. However, these results are even worse than value investors have experienced in the broader market. We believe the unique dynamics of network effects - positive feedback and monopoly - are subverting mean reversion in this particular subset of stocks.


Network Valuation

We believe the problem is that financial accounting metrics do not capture the intangible value of network effects. If we want to succeed in a market increasingly dominated by platform stocks, we need ways to value networks.


There are many ways to quantify network health. Of course, the most important metric of network strength is growth, which can be measured both in terms of the number of users and the overall level of activity. The second most important metric is user lock-in, which measures how hard it is for users to leave for competing networks.


There are many other metrics that can help further refine our view of network performance. Are users being acquired organically? What is the cost of customer acquisition? How engaged are users? How have these metrics evolved by cohort? How do they differ by geography? For marketplaces, what is the match rate and are supply and demand balanced?


We will now address the two most important measures of network health: growth and lock-in.


Growth

Positive feedback means that investors must carefully monitor network growth. Accelerating growth could indicate a platform is tipping the market while deceleration could portend an impending death spiral.


One comment that gets tossed around is that “venture capitalists are momentum investors and public market investors are value investors.” For platforms, the venture strategy of buying winners and selling losers makes sense in the presence of positive feedback.


Unfortunately, the metrics used to track network growth vary widely by company. For instance, Uber reports monthly active users, trips and gross bookings while Facebook discloses their monthly and daily average users and average revenue per user. As these are non-GAAP metrics, they are often buried in the unstructured portion of companies’ quarterly filings and are not always disclosed.


While we could use NLP to extract this unstructured data, an even better approach is to leverage now ubiquitous alternative data. These data can provide a higher frequency measure of network health.


We’ll use restaurant delivery as a test case. While there are specialized services that measure website traffic, app usage and credit card purchases, we will use search query data from Google. This provides a reasonable metric inasmuch as hungry users begin their quest for food by typing a term like “Grubhub” into Google.


Exhibit 21

Google Search Interest

Source: Google, Sparkline

We find that all the major food delivery services attracted increasing interest over the past six years with the exception of Seamless. Demand spiked in March and April 2020 as Covid-19 shut down restaurants and forced people to eat at home.


Normalizing this data to 100% gives us a chart of market share. While Grubhub and Seamless were early market leaders, DoorDash has managed to capture around half the market. Although it only provides data for two dates, DoorDash’s S-1 confirms our data is in line with their own estimates.


Exhibit 22

Food Delivery Market Share

Source: Google, Sparkline

This example provides a quick illustration of the utility of alternative data in providing a high frequency handle on growth and competitive positioning. Positive momentum is particularly important for platforms given the “go big or go home” nature of network effects.


As a fun bonus, the following exhibit shows the average strength of each service by state over the past six years. Seamless has been strong in New York City and Postmates flourished in Las Vegas.


Exhibit 23

Local Network Effects

Source: Google, Sparkline

This provides a great real life example of local network effects. While DoorDash has the strongest overall network of drivers, restaurants, and diners, its competitors maintain dense clusters in particular geographies.


Lock-In

In order to assess the defensibility of a company’s network, investors need to understand the concepts of switching costs and multihoming.


Switching costs are the costs faced by users leaving for a competing network. They include the cost of breaking legal contracts; buying expensive platform-specific durable hardware; learning to use a new system; migrating data from a proprietary format (e.g., ERP systems); rebuilding positive reputation (e.g., Yelp, Amazon); and rebuilding a subscriber base (e.g., Twitter).


Multihoming is a related concept that refers to the tendency for users to also utilize competing products. For example, it is common for drivers to work for both Uber and Lyft. However, it is less common for someone to own both an iPhone and Android phone and even less common for a hospital to have two EMRs. Multihoming weakens networks by making it easier for users to defect to competitors.


“Envelopment” is a competitive tactic platforms use against each other. It involves taking users from a competing platform by combining one’s own functionality with the target’s to create a multi-platform bundle. For example, Microsoft used envelopment to defeat Netscape in the browser wars of the 1990s. More recently, Facebook used this tactic on Snapchat with its “Stories” feature. Firms with networks overlapping (Snapchat) or even simply adjacent (Netscape) to those of formidable competitors are more vulnerable, all things equal.


The Future of Platforms

Cross-Industry Adoption

While platforms now dominate the communications and technology industries, they have not experienced widespread adoption in less information-intensive industries. It is hard to think of many successful platforms in industrials, energy, and materials.


Exhibit 24

Platform Adoption By Industry (US Top 500)

Source: S&P, SEC, Sparkline

While the tech industry will likely become even more saturated with platforms, in order for platforms to further impact the stock market, they will need to break into other industries.


One innovation that might produce this outcome is the Internet of Things. Platforms facilitating the communication of machines (e.g., self-driving cars, buildings, wearable electronics, heavy machinery) with each other have considerable potential to transform the industrial economy.


In financials, we are starting to see fintech platforms gain traction in payments, peer-to-peer lending and insurance. Blockchain technology could provide a further opening for the platformization of the financial sector.


Platforms offer a potentially more efficient way to organize economic activity. Thus, it is likely they will play at least some role as technology ultimately infiltrates finance, industrials and other asset-heavy sectors.


Rising Valuation

We found that platforms have historically been undervalued relative to the strength of their businesses. However, the market seems to be gradually waking up to the power of network effects.


Exhibit 25

Relative Valuation of Platform Companies

Source: S&P, SEC, Sparkline

Over the past few years, the relative valuation of platform companies has increased by around +85% when measured against sales or book value. However, the increase is a more muted +33% compared to earnings as platforms have also increased their profitability advantage over the market.


Much of this effect is not specific to platforms but is the consequence of the market's recent obsession with hot IPOs. It just so happens that many extremely richly-valued IPOs are also platforms, such as Snowflake (P/S of 360), DoorDash (P/S of 26) and Airbnb (P/S of 56). Removing these stocks cuts the valuation increase in half. However, established platforms have still seen relative valuations rise modestly.


While we believe platforms generally remain undervalued, we need to be a bit more discerning. In particular, investors should be careful not to blindly buy into platforms that are also hot IPOs pricing in unrealistic growth.


Governance and the Gig Economy

The most significant societal impact of platforms stems from their externalization of the means of production. Rather than hire employees, these companies manage vast networks of independent contractors. This has fueled the growth of the so-called “gig economy.”


On one hand, the gig economy offers high levels of flexibility and autonomy and opportunities to workers who might otherwise be excluded from the labor market. However, concerns have also arisen over the laws and regulations that have not yet adapted to this new economic model.


One important issue is the employment status of external workers. The most politicized example is of Uber drivers. Uber wants these workers classified as contractors in order to avoid having to pay payroll taxes, minimum wage, and benefits.


A second issue is the responsibility of publishing platforms like Facebook and YouTube to police third-party content. While controversy first centered on copyright infringement, the most important issue today involves fake news and hate speech. As we saw with the recent presidential elections, extremists and state actors will go to great lengths to weaponize tech platforms.


Platforms came of age in a period of lax regulation as regulators and public opinion slowly came to grasp their profound societal impact. However, we are likely nearing the end of this grace period. We expect platforms will ultimately have to take on more responsibility for the participants in their communities. Platforms are often compared to nation states and may soon be expected to practice governance principles befitting this role.


Mega-Platforms and Antitrust

Until recently, the trend has been toward the consolidation of platforms into a few mega-platforms that bundle together a wide variety of services. Google users can get email, cloud storage, navigation, search, browser, spreadsheets, and video conferencing without having to leave the ecosystem.


We expect this trend to slow and possibly reverse due to regulatory backlash. Over the past few months, Google and Facebook have been served with antitrust lawsuits. Pressure is mounting for Facebook to divest Instagram and WhatsApp.


Even the Chinese government has started cracking down on tech monopolies. China is perhaps even more platformized than the US, with China’s BAT (Baidu, Alibaba and Tencent) enjoying an even greater concentration of power than our FAANG. Among other antitrust moves, the Chinese authorities scuttled the $37 billion IPO of fintech giant Ant Group after publicly chastising its founder, Jack Ma.


Overall, it feels that the political winds are shifting against giant tech companies. While this will likely limit the growth of mega-platforms, it may foster the emergence of more independent single-product platforms.


Conclusion

Platforms have become a dominant economic force. Their ascent has disrupted dozens of industries, created massive concentrations of power, and transformed many aspects of society.


However, investors have been slow to recognize the power of the platform business model. Platforms have handily outperformed the stock market for over a decade. We believe this is due to the complexity of cleanly identifying platform companies and valuing intangible network effects.


Network effects lead to positive feedback and monopoly, which disrupt traditional investment approaches. Given their increasing importance, investors would be well served to devote resources to deeply understanding the platform business model.

Disclaimer

This paper is solely for informational purposes and is not an offer or solicitation for the purchase or sale of any security, nor is it to be construed as legal or tax advice. References to securities and strategies are for illustrative purposes only and do not constitute buy or sell recommendations. The information in this report should not be used as the basis for any investment decisions.


We make no representation or warranty as to the accuracy or completeness of the information contained in this report, including third-party data sources. The views expressed are as of the publication date and subject to change at any time.


Hypothetical performance has many significant limitations and no representation is being made that such performance is achievable in the future. Past performance is no guarantee of future performance.


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